News Analysis date published New: 
Monday, October 15, 2012 - 14:30
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Monday, October 15, 2012 - 15:02
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Monday, October 15, 2012 - 14:30

Why the Stunning Natural Gas Rally is Far From Over

Monday, October 15, 2012 2:30 PM

If you were in a room of investors this past spring and told them that natural gas prices would soon stage a stunning rebound, then you would have been laughed out of the room. After all, the country was facing a major gas glut that within just a few months threatened to fill up our nation's energy storage system completely.

Of further concern back then: though the number of gas rigs in service had been steadily falling, the remaining rigs that were still in use were pumping out much more natural gas than geologists had assumed. Yet thanks to rising demand for gas, especially at power plants that switch from coal to gas (C2G), prices indeed firmed up -- spectacularly so.

But unfortunately, investors' minds are still stuck in the past. The press is filled with reports calling for a big pullback in natural gas. They cite technical factors such as over-extended price and the possibility of a decision by power companies to switch back to coal. Yet for a slew of reasons, gas prices can extend this gain, perhaps to the $4 or even $5 per thousand cubic feet (MCF) mark by next spring. [Nathan Slaughter, editor of StreetAuthority's Scarcity & Real Wealth newsletter, echoed my sentiment, calling for $4 natural gas by the end of 2013 in this article.]

Here's why...

The C2G switchback?
To suggest that power producers will bail on gas and go back to coal makes little sense. Even after this run, gas is still cheaper than coal as a power source. Of course, if gas moves up toward the $6 per MCF level, then the economics switch in favor of coal. That's why we won't be seeing $7, $8 or $9 natural gas any time soon. Gas at $5 MCF, however, is still a perfectly comfortable level for power producers.

The rig count lag
As noted earlier, the number of gas rigs in service has been falling for several years. In January, I noted the steady drop in active gas rigs, suggesting that when the rig count fell to 725, it was time to start buying natural gas stocks. That call was premature, but by the time that figure fell toward the 600 mark, a change had begun. At the start of the third quarter I took a fresh look at the natural gas industry, noting that the rig count had fallen to 534. Then, Nathan Slaughter took another look at the beginning of this month, when the rig count had fallen to just 454.

By then, what we both predicted had already begun: gas prices had rebounded 40% off their lows, and they've risen another 30% since my updated look. If you're keeping score, then you should know the natural gas rig count stands at 422, according to oil and gas producer Baker Hughes (NYSE: BHI). This is the lowest level in 13 years.

Here's the important point about the rig count... Gas wells are initially quite productive, but as time passes, production starts to diminish. So those 422 rigs are collectively bound to produce less natural gas as time passes.

Of course, the industry won't stand by as production falls. Expect it to start putting more rigs back into service, though only enough to offset the supply declines from existing rigs. This industry isn't historically known for production discipline, but the recent gas price plunge has finally changed the industry's "pump at any cost" mantra.

The demand side
With supply likely to remain in check, the demand side of the equation is moving into the spotlight. And energy experts like Nathan have rightly noted that our natural gas is so much cheaper than in places like Japan and Europe, that United States is getting ready to become an export powerhouse. Much has been written about Cheniere Energy's (NYSE: LNG) imminent construction of a major liquefied natural gas facility in Sabine Pass, Louisiana, but a half dozen other firms are moving forward with plans to construct export facilities along the U.S. Gulf Coast as well.

And as The Wall Street Journal recently noted, major oil firms might make a similar push in Alaska. Constrained supply and rising demand are the perfect backdrop for more price gains.

As noted, Nathan doesn't see gas prices hitting $4 until the end of 2013. That's the same sentiment of gas traders, who don't expect prices to reach $4 until October 2013, and don't anticipate a move to $5 for several years. Yet analysts at Morgan Stanley argue that the "forward curve is still too cheap." They looked at current supply and demand trends (even before the export opportunity noted above) and now say that producers have become almost too constrained in their output. Assuming these producers don't start to add a lot of new supply to the market, then the Morgan Stanley analysts see natural gas prices hitting $4.80 per MCF by the first quarter of 2013.

Almost no one else is talking about this right now. No one was talking about $3.60 gas this past spring, either.

Risks to Consider: The biggest risk to natural gas prices is a mild U.S. winter, which was the case a year ago. Forecasters currently anticipate a typical winter heating season, though you need to keep monitoring these forecasts if you own gas stocks.

Action to Take --> If these analysts are correct, then investors stand to make big gains. We've already noted that natural gas producers have recently lagged rising natural gas prices, but don't expect that to last for long. With natural gas prices expected to continue rising, expect natural gas producers to make up for lost ground in short order. Below are some of my favorites...

  • Ultra Petroleum (NYSE: UPL), one of Nathan's Scarcity & Real Wealth holdings, actually generates 90% of its revenue from natural gas, not petroleum.
  • Southwestern Energy (NYSE: SWN), one of the lowest-cost gas producers, and with 99% of its production tied to gas, brings ample leverage to rising gas prices.
  • Marathon Oil (NYSE: MRO), which has underperformed the peer group during the past six months on concerns that its acreage in the Eagle Ford Shale won't be as productive as rivals such as EOG Resources (NYSE: EOG). But management insists that early production results are coming in much better than industry analysts are anticipating.

[Note: Natural gas isn't the only opportunity Nathan is finding in the commodity market right now. In fact, Nathan has his eye on a situation in Russia that could dry up as much as 10% of America's electricity supply. As the country scrambles to react, a small group of stocks could soar. And all of this could happen as soon as early 2013. For more information on the potential crisis, and how to profit, follow this link.]

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of UPL,MRO in one or more of its “real money” portfolios.